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Monday, July 20, 2009

Stock Picker’s Market

We frequently hear people claim that we’re in a “stock picker’s market” or that a “sideways market favours stock pickers.” Superficially the logic of this can seem compelling: When stock market returns are low, you can only get a high return by picking the right stocks. But, this logic doesn’t hold up to analysis.

Problem #1: Identifying the type of market.

When someone says “we’re in a sideways market,” this is a prediction that short-term stock returns will be low. This prediction may be based on the fact that returns were low in the recent past, or may be based on other factors, but there is little evidence that anyone can predict short-term returns. I simply don’t believe that any commentator really knows what will happen in the short term.

Problem #2: Stock pickers don’t outperform, on average.

Even if we knew that returns will be low for the next year, who says that a stock picker will pick the right stocks to get higher returns? Because of trading costs, the average stock picker must get lower returns than the market average.

The next time you hear that we’re in a stock picker’s market, you may find that the source of this wisdom is someone who makes a living picking stocks with other people’s money.